Tuesday 21 June 2016 by Opinion

Strategies for buying non AUD denominated bonds

We’ve had a good couple of questions from Queensland resident Gary Wilson that echoes what we are often asked in relation to buying non AUD denominated bonds. When is the best time to buy non AUD bonds? What strategies can we use to time this right?

beach

The short answer

The short answer to this is that you need to firstly wait for a time at which the AUD is higher than its “fair value”.  Fair value depends upon the individual’s view, but I have long considered the AUD:USD fair value to be 65 to 70 cents”.  When the AUD is above this range, you need to find bonds that represent good value, that is, they are at a low price relative to their risk. There is also a strategy unique to Australian investors, where a jump in iron ore prices gives rise to the opportunity to buy gold miners, which I’ll explain later in the note.

The longer (more complicated) explanation

The longer answer requires an “unpacking” of what makes up the price of a bond on any given day.  The price of a bond is based on three factors:

  1. “Risk free” bond yields, for example government bonds (a rise in government bond yields will push the yield on all bonds higher, all other things being equal).
  2. The credit spread, that is, the extra yield that the market demands for that company’s specific risk.
  3. Liquidity factors, being the extra margin that a buyer has to pay if the bonds are held tightly or the extra margin that a seller has to give away if there are not enough buyers. 

So there’s really two parts to the answer for this:

  1. Risk free bond yields, typically highly correlated to currency

    The price of a USD denominated fixed rate bond will fall when the yield rises, as per any fixed rate bond.  However there is a correlation between government bond yields and currency; namely that higher yields tend to result in higher currency levels. This is because the more attractive they are, the more capital flows into those bonds and therefore the more of that currency is bought to buy the bonds.  So this relationship works against the Australian investor looking to set their timing at a low point for the USD ( high point for the AUD against the USD) and a high yield ( a low bond price).

  2. Fundamental credit risk, typically not meaningfully correlated to currency other than for the resource sector
  3. The yield on a bond is made up of the risk free rate plus the “spread”.  The spread will depend upon fundamental risk factors such as economic cycles that will push all spreads higher or lower, sector specific factors that will only impact certain sectors, or company specific factors that will only impact the spread on that one company, for example interest coverage. 

Generally speaking, the best strategy for finding a bond at a good price at a time when the AUD is high, is to wait for the AUD to trade above its fair value and then look for bonds offering good value.  The AUD level and credit spreads will typically move independently, so good value should be available in some parts of the market, with one notable exception for Australian investors: resource companies. This exception creates a scenario when this strategy doesn’t work, and a scenario in which it works extremely well.

Commodity price rises will put downward pressure on credit spreads. A fall in credit spreads increases bond prices.  So a rise in commodity prices will put upward pressure on mining company bond prices. Of course, this depends on the commodity and the company. For example a rise in iron ore will put upward pressure on Fortescue or BHP’s bond price, but not Newcrest; whereas a rise in the gold price will push up Newcrest bond prices but have no impact on Fortescue. 

The unusual situation for Australian investors is that our currency is also driven by fluctuations in commodities; the AUD will typically rise and fall with commodity prices.  So while the strategy to find a mining company bond at a lower price calls for the investor to wait for a fall in the price of the commodity that company produces, any benefit of a lower bond price could be wiped out by the opposite impact on the currency.  That is the scenario in which this strategy doesn’t work. 

But the opportunity in the commodity AUD correlation is that if, for example, the iron ore price rises, the AUD is likely to follow it upwards.  However a jump in the iron ore price will not push up the bond price and therefore the price of say a gold mining company.  The investor then has the combination of a higher AUD without paying more for the bond.  In this scenario, buying FMG bonds in USD would result in paying more for the bond (due to lower spreads) but getting more for AUD, offsetting each other.  But buying Newcrest bonds in USD would result in paying the same for the bonds (no change in spreads) but getting more for the AUD.